A Toast to Overdraft Fees — And How to Avoid Them

(photo: [puamelia])

Last year, as you may recall, the Federal Reserve gave banks an ultimatum: if they wanted to continue charging customers up to $35 for each checking account overdraft, they’d have to get “opt-in” permission from the account holder.

In other words, the bank gave you a choice: opt into the program, and the bank will continue to allow you to overdraw your checking account (and levy the charge) via ATMand debit transactions. Opt out, and those transactions will be declined; you may lose face at the checkout, but at least you’re not $35 poorer. (If you don’t remember making such a choice, well, more on that in a minute.)

This was last August. At this point, we have essentially no idea how many people took the red pill and how many took the blue pill. The Federal Reserve doesn’t know. The FDIC doesn’t know. Last week a bank industry consultant in Illinois made headlines by claiming that over 75% of people have opted in; he wouldn’t show me his data and other analysts I spoke to were skeptical.

Here’s what we do know, however: most people have access to cheaper alternatives than fee-based overdraft coverage. If you have a checking account, it’s time to flip your ATM card over, call the 800 number, and find out what kind of overdraft coverage you have. Because the fee-based kind that dominates the industry is about the most expensive way you can possibly borrow money.

The cost of overdraft

Say you opt into fee-based overdraft coverage. When you overdraw your account, the bank makes you a loan. The loan might be as small as a couple of bucks if (as the example always goes) you were debiting a cup of coffee. If you’re charged $35 and pay the bank back in a few days, that’s the equivalent of borrowing an astronomical rate of interest.

When the FDIC looked into overdraft in 2008, they ran a model scenario in which a customer with an empty checking account withdraws $60 from the ATM, gets socked with a $27 fee (the industry average at the time), and pays it back in two weeks. That amounts to an annual interest rate of 1,173%, which makes payday lending look flat out charitable.

You probably know all this already. Want options? Here are a few.

How hardcore are you?

Most people—about 75%, according to that FDIC study—never overdraw their account. If you’re in that category (be honest), you don’t need to care about this at all. (By the way, this FDIC data predates the Great Recession, so the percentage of squeaky-clean non-overdrafters has probably dropped somewhat.)

We can divide the rest into two categories. The hardcore and the oopsies. (I made these terms up. Can you tell?)

Hardcore overdrafters are the 14% of bank customers who overdraft five or more times a year and generate 93% of all overdraft fees. These folks, for the most part, are not accidentally charging one latte too many. They’re people with low credit scores (but not necessarily low income) who are using overdraft as an alternative to payday loans.

“The serial overdrafters are also the least likely to have other alternatives,” says Greg McBride, a senior analyst for Bankrate. “In this era of tight credit, they probably don’t have credit cards, or they don’t have available credit on their credit cards.”

If you’re in this situation, you don’t need me to tell you you have a problem. If the problem is overall indebtedness, consider Consumer Credit Counseling. Alternatively, if you have a revolving payday loan or overdraft that you can’t seem to get rid of, you might find a local bank or credit union that offers small dollar loans (SDLs). These are loans of up to $2,500 with capped interest rates that are specifically designed to replace payday lending and overdraft. Here’s a list of banks that participated in an FDIC small dollar loan pilot program; many still offer the service.

Oopsies are the other 11%, who have an occasional overdraft (one to four per year). If you’re in this category, where overdraft is a genuine oversight and not a lifestyle, you’ve got plenty of choices.

Options for Oopsies

For a rundown of the choices available to occasional overdrafters, let’s turn to an unlikely source: Bank of America (BAC).

To hear the American Bankers Association tell it, bank customers find overdraft protection convenient and the fees reasonable. “People want this service, and they’re willing to pay for it when they need it,” says ABA spokesperson Carol Kaplan.

Tell that to B of A, which no longer offers fee-based overdraft because they said customers didn’t want it. (Citi doesn’t offer it either.) Instead, the bank offers several options:

* Link your checking account to another checking account or savings account. Money will be automatically transferred into the empty checking account from the linked account. A $10 fee applies, but only once a day and only if you overdraw your account by more than $10.

* Link your checking account to a line of credit. When your account hits zero, you start dipping into a credit line. There’s no charge other than the interest on the credit line, which is comparable to a credit card. You have to have a decent FICO score to qualify for this.

* And, of course, you can simply decline overdraft protection completely and have your transactions denied.

Insure yourself

No one ever needs to pay an accidental overdraft fee. If you’re not good at keeping tabs on your balance, you can opt out the coverage and carry a credit card (or even a prepaid debit card, as long as it’s a low-fee one) as backup. You can ask your bank about lower-cost options. You can switch to a bank or credit union with kinder, gentler policies. (My credit union, for example, offers the automatic transfer option at no charge and the line of credit at reasonable rates.)

So why are people still opting in? Beats me. “Look, the problem isn’t that overdraft protection exists,” says Bankrate’s McBride. “The problem is, people spend more money than they have in the account.”

I’ll drink to that.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.